Nonlinear Policy Behavior, Multiple Equilibria and Debt-Deflation Attractors

This paper analyzes global dynamics in a macroeconomic model where both monetary and fiscal policies are nonlinear, consistent with empirical evidence. Nonlinear monetary policy, in which the nominal interest rate features an increasing marginal reaction to inflation, interacting with nonlinear fiscal policy, in which the primary budget surplus features an increasing marginal reaction to debt, gives rise to four steady-state equilibria. Each steady state exhibits in its neighborhood a pair of ‘active’/‘passive’ monetary/fiscal policies à la Leeper-Woodford, and is typically investigated in isolation within linearized monetary models. We show that, when global nonlinear dynamics are taken into account, such steady states are endogenously connected. In particular, the global dynamics reveals the existence of infinite self-fulfilling paths that originate around the steady states locally displaying either monetary or fiscal ‘dominance’—and thus locally delivering equilibrium determinacy—as well as around the unstable steady state with active monetary-fiscal policies, and that converge into an unintended high-debt/low-inflation (possibly deflation) attractor. Such global trajectories—bounded by two heteroclinic orbits connecting the three out-of-the-trap steady states—are, however, obscured if the four monetary-fiscal policy mixes are studied locally and disjointly.